It is no secret that over the past two months, Goldman has commenced a full endorsement of Nominal GDP targetting as a method to stimulate the economy, not to mention Wall Street's bonus pool, after Ben Bernanke completely ignored Hatzius' advice to reduce the Interest on Overnight Excess Reserve rate as well as subsequent pleading for a start of MBS LSAP. Mathematics once again aside, and as we demonstrated, the math works out to an non-trivial incremental $10 trillion in debt through 2016 on top of what will be issued, to catch up with the GDP growth run rate and to eliminate the excess slack in the economy, the question is whether NGDP would achieve any tangible stimulus at all, or merely reduce the Fed's ever smaller arsenal of non-conventional means to boost the economy by one more approach. The attached rhetorical Q&A just released by Goldman seeks to answer that and any other left over questions one may have on NGDP as a policy measure, and further puts out the inverse strawman argument that it is not coming out any time soon. To wit: "We do not expect a move to an NGDP target anytime soon, although the probability would increase if growth and/or inflation slowed by more than we currently estimate." Then again, with the whole reverse psychology trademark inherent in every piece of Goldman public product, and considering the squid's previous advances to determine monetary policy have been snubbed, it may just mean that the next time the US economy implodes, this is precisely the method the Fed may use in early 2012 to guarantee another record year of Wall Street bonuses considering 2011 will be abysmal for so many Swiss and other offshore bank accounts.
From Goldman Sachs:
US Economics Analyst: 11/45 - Inflation vs. NGDP Targeting at the Fed
- It is possible that Fed officials will soon adopt an explicit flexible inflation target. This would only be a small step away from the current framework, in which they talk about the “mandate-consistent” inflation rate of 2% or slightly below. However, we think it would be somewhat counterproductive at the margin because it would cement the asymmetry between the employment and inflation part of the Fed’s dual mandate. This risks solidifying expectations of low growth.
- A move to a nominal GDP (NGDP) target would stand a better chance of helping the Fed achieve both parts of its dual mandate over time. It would provide a way to strengthen the employment side of the mandate, while allowing for errors in the estimation of potential output. If combined with a commitment to use the remaining tools of monetary policy aggressively, our analysis suggests that it could potentially give a significant boost to growth and employment.
- An NGDP target does involve some risk of an unwanted increase in long-term inflation expectations. However, this risk would be lower than under other “unconventional unconventional” options such as a higher inflation target because an NGDP target involves a clear exit strategy for when to apply the monetary brakes. If Fed officials want to build in additional safeguards, they could add ceilings for NGDP growth or inflation, aim for only a partial return to the pre-crisis NGDP level trend, or treat NGDP merely as a kind of intermediate target. Of course, these tweaks would also make the shift less powerful.
- We do not expect a move to an NGDP target anytime soon, although the probability would increase if growth and/or inflation slowed by more than we currently estimate. Our baseline forecast remains a return to quantitative easing via purchases of agency MBS as well as Treasuries, announced in the first half of 2012.
The last few weeks have seen a lively debate on potential shifts in the Fed’s monetary policy framework. Rumblings of a move to an explicit inflation target have increased and there has been an extensive debate about the benefits and drawbacks of an NGDP target in the media. Fed Chairman Bernanke addressed both issues in response to questions in his post-FOMC press conference. Today’s article considers some of the points that have come up in this debate in Q&A form.
Q: There has been increased talk recently that the Federal Reserve may soon adopt an explicit inflation target. Is this likely?
A: It’s certainly very possible. Chairman Bernanke is a long-standing advocate of inflation targeting. It was discussed at the September meeting, and Bernanke has mentioned it in recent speeches and congressional testimony. Moreover, it appears that Fed officials have the legal authority to adopt an explicit inflation target without congressional sign-off. If the FOMC decided to adopt an inflation target, it would undoubtedly be a “flexible” one—that is, it would explicitly allow for significant short-term deviations from the target for the sake of output stabilization.
Q: Would such an explicit inflation target be a good idea?
A: It probably wouldn’t make much difference compared with the current framework for monetary policy. Already, Fed officials talk about the “mandate-consistent” inflation rate of 2% or a little less. Moving from this to a flexible inflation target would only be a small step.
That said, we believe that such a step would be somewhat counterproductive at the margin under current circumstances. By elevating the status of inflation further, it would cement the asymmetric treatment of the two parts of the Fed’s dual mandate. Chicago Fed President Evans recently explained this asymmetry as follows:
“Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire.”
Evans believes that this asymmetry is a problem, and we agree with him. In fact, we believe that this is a particularly important issue at the moment because over 40% of all unemployed workers have been out of a job for more than six months. As explained by Chairman Bernanke in his 2011 Jackson Hole speech, this raises the risk that they will ultimately become unemployable, which substantially increases the long-term costs of unemployment.
Q: Doesn’t the asymmetry between the Fed’s employment and inflation goals just reflect the inherent preferences of central bankers?
A: No, we don’t think that explains it. Kenneth Rogoff of Harvard University—best known for his 2009 book This Time Is Different with Carmen Reinhart—showed in the 1980s that it makes sense for politicians and voters to appoint central bankers with preferences over employment and inflation that are more conservative—in the sense of putting a higher weight on keeping inflation low relative to keeping employment high—than their own.
Evans starts from the assumption that a reasonably conservative central banker would weight a deviation of inflation from the target four times as heavily as a deviation of real output from potential. He shows that this would still imply equal weights on the unemployment gap and the inflation gap. The fact that Fed officials seem to be less alarmed about 9% unemployment than they would be about 5% inflation says that they are treating the two parts of their mandate in an even more asymmetric fashion than Evans’ conservative central banker.
Q: In order to straighten out this asymmetry, should Fed officials pair an explicit inflation target with an explicit employment target?
A: No, we don’t think that would be a good idea. Under the current approach, the asymmetry between inflation and unemployment, while problematic, is somewhat unavoidable. An inflation gap is plain for everyone to see. In contrast, nobody can be absolutely sure that a measured employment gap actually exists. It is always possible that what looks like a large employment gap is in fact due to a large increase in the natural rate of unemployment. To be clear, we do not believe that this is the case in the current situation; in fact, we are quite confident that there is really a lot of cyclical slack in the economy. However, we recognize that it is difficult to be 100% sure, and that other economists—including a number of FOMC members—have a different view.
If Fed officials can’t be certain about the size of the employment gap, they will be unable to define a clear employment target in the same way they can define a clear inflation target. After all, they just might find that they cannot hit the employment target without a lot more inflation.
Q: So what should Fed officials do instead?
A: One way to address the asymmetry without resorting to a hard employment or output target—with the problems that this could entail—would be to target the level of nominal GDP extrapolated from the pre-crisis trend. This would effectively increase the weight of the employment part of the dual mandate while allowing Fed officials to hedge their bets with respect to uncertainty about the natural rate of unemployment or the level of potential output. It is a way for them to focus on a nominal variable over which they have a substantial amount of control, while leaving the split of nominal GDP between real output and inflation up to the supply side of the economy.
An example should make clear why an NGDP target can act as a hedge against output and employment gap estimation errors. Suppose the Fed decides to target the path shown in Exhibit 1, calculated as the level of nominal GDP in the fourth quarter of 2007 extrapolated at a 4½% annual rate (2% for inflation and 2½% for real potential GDP growth). This implies that nominal GDP in the third quarter of 2011 was about 10% below trend. Data from the Congressional Budget Office (CBO) imply that about 6 percentage points of this gap was due to a shortfall of actual real GDP compared with potential real GDP. If this estimate is correct, it would imply that an elimination of the NGDP gap will ultimately result in an extra 4 percentage points of cumulative inflation (e.g. an extra 1 percentage point over a 4-year period). At the end of the transition period, inflation would be expected to fall back to the target.
So what happens if the output gap is smaller than 6%? An RDGP or employment target would be very problematic because it would commit the Fed to a goal that cannot be reached without creating larger and larger amounts of inflation. But an NGDP target would significantly reduce this problem by automatically capping the acceptable cumulative amount of inflation. Once the level of NGDP has risen back to the pre-crisis trend, it would be clear that Fed officials have to tighten monetary policy, and this would eventually bring inflation back to the long-term target.
Q: Could a shift to an NGDP target unmoor long-term inflation expectations?
A: Such an outcome is clearly a risk with any sharp change in the monetary policy framework in a more expansionary direction. However, we believe it is a smaller risk than under shifts such as an outright employment target or an increase in the inflation target. This is because there is a natural “exit strategy” for the tightening of monetary policy once NGDP is back on the target path.
If the risk still seems too large, Fed officials could modify the NGDP target in a number of ways. First, they could target not only the ultimate NGDP level but also the NGDP growth rate during the transition period. For example, they could stipulate that NGDP can grow at no more than an 8% pace, even if the level of NGDP is still far below the target path. Similarly, they could supplement the NGDP level target with an inflation ceiling.
Second, they could set a less ambitious NGDP target than that shown in Exhibit 1. For example, they could restrict themselves to closing an NGDP gap that is equivalent to the currently estimated RGDP gap of 6%. In this case they would expect to generate no above-target inflation during the transition period, at least on average; if the RGDP gap is in line with current estimates, they would expect the extra NGDP growth to translate entirely into additional RGDP growth.
Third, Fed officials could move more incrementally, adding NGDP to a longer list of intermediate targets that might already include asset prices or bank lending conditions. Chairman Bernanke indicated some sympathy for this option in response to a question at his most recent post-FOMC press conference.
Of course, all of these mechanisms involve costs. The first option would be clumsier and more complicated than the crisper pure NGDP level target. Meanwhile, the second and third options would make the shift significantly less powerful and would therefore reduce the potential benefit from an NGDP target. But if Fed officials were looking for a “halfway house” that is closer to the current regime, such options are available.
Q: Why should we expect an NGDP target to be expansionary? After all, Fed officials only have a very limited instrument set.
A: It is true that the instrument set is limited, as Congress is unlikely to cooperate with the Fed by easing fiscal policy significantly and/or providing funds for purchases of private-sector assets. That said, we believe that the combination of a clear NGDP target and aggressive use of the remaining tools could be quite an effective combination. It could (1) lower nominal interest rates via expectations of a later start to rate hikes, (2) lower nominal interest rates further via purchases of long-term securities and thereby a reduction in the term premium, (3) raise near-term inflation expectations and thereby lower real interest rates yet further, and (4) increase expected output and thereby raise the incentive to invest in added productive capacity.
The latter two points assume that the regime shift leads to a meaningful change in inflation and output expectations, which is not certain. However, in our model presented a month ago, which is based on empirical estimates of the linkage between spending and expectations, these expectational channels are quite powerful. Exhibit 2 shows that the combination of an NGDP target and renewed QE might lower the unemployment rate by nearly 2 percentage points by the end of 2014, compared with the “baseline” scenario, in which the Fed just follows our estimated Taylor rule. Exhibit 3 shows that the policy might boost inflation by ½-1 percentage point, although this is relative to a “baseline” prediction of inflation well below the Fed’s implicit target. Analysis of the regime shifts by the Fed and the Swedish Riksbank in the 1930s also suggests that such shifts can be powerful even if the instrument set is limited.
It is also worth noting that if an NGDP target turns out to be insufficiently effective because of a lack of available policy instruments, the shift probably wouldn’t do any harm. It would still serve as a signal that Fed officials are likely to keep interest rates low and the balance sheet large for a very long time, which would still be better than the alternative of not signaling such relatively accommodative policies. So even if there is only a good chance—rather than a certainty—that an NGDP target would bring them closer to meeting its dual mandate, Fed officials may nevertheless want to move in this direction on cost-benefit grounds.
Q: Is it likely that the FOMC will soon adopt an NGDP target?
A: We certainly do not expect a full-blown NGDP target along the lines of Exhibit 1 anytime soon. It would be quite a radical move for the Federal Reserve, an institution that typically moves in a deliberate manner.
However, we see a somewhat bigger chance of a gradual move toward an NGDP target that is “watered down” with some of the modifications described above. First, if there is one central bank in the world that could conceivably go down this route, it is probably the Federal Reserve because of its dual mandate. Most other central banks operate under mandates that focus mainly or exclusively on the delivery of low and stable inflation.
Second, the “optics” of an NGDP target are much better than those of other “unconventional unconventional” monetary policy steps such as a higher inflation target or a price level target. It is deeply counterintuitive to most people that higher inflation per se could help the economy grow faster, because they think of higher inflation as a cut in real income. This is not really correct because a higher inflation target would imply a higher target for wage as well as price inflation, i.e. it wouldn’t have direct implications for real incomes. But it is nevertheless much easier to convince people that a higher target for overall income and spending in the economy might have an expansionary impact. This means that if the Fed decided that a substantial amount of added stimulus was needed—more substantial than what’s available via “conventional unconventional” means such as further QE—an NGDP target would be a natural option.
Third, an NGDP target enjoys growing support from economists on both sides of the political aisle. Several prominent economists who have recently advocated NGDP targeting, including Paul Krugman, Christina Romer, and Bradford DeLong, lean toward the Democratic side. However, many of the long-standing “market monetarist” supporters of NGDP targeting such as Scott Sumner and David Beckworth identify themselves as political conservatives. Beckworth recently wrote an article advocating NGDP targeting with political journalist Ramesh Ponnuru in the conservative National Review. Gregory Mankiw, an adviser to Republican presidential candidate Mitt Romney, has in the past also published research favorable to NGDP targeting, although he has to our knowledge not weighed in on the current debate.
Weakness in actual NGDP would increase the probability that the FOMC might go down this path. Although the recent data on US economic activity have looked a bit better recently, we do expect NGDP growth to slow from the 5% pace of the third quarter to only about 2½%-3% in the first half of 2012. This is both because we see real GDP growth slowing due to greater spillovers from the European crisis and tighter US fiscal policy, and because we expect a meaningful slowdown in inflation.
Q: So what is your actual forecast for Fed policy?
A: We expect another quantitative easing program to be announced sometime in the first half of 2012. The timing, size, and asset mix will depend on how the economy performs, but it seems likely that agency MBS would be included in any new program.
We should also see the FOMC take further steps to clarify its policy framework. An explicit inflation target is possible, and a move to start publishing information about the path for the federal funds rate expected by different FOMC members is quite likely. We believe that an NGDP target could usefully complement these steps, although we recognize that it would be a large shift in the framework that is unlikely to happen overnight.